Monday, September 21, 2009

Not as Bad as You Think?

A year has passed since the tumult surrounding the collapse of Lehman Brothers pushed the already sinking global economy into its worst recession in the post-war period. Much has changed in that year, so much so that the once doomed U.S. economy -- the epicentre of the global downfall -- has turned full circle and is now widely projected to be out of recession. Some even say the country is on the verge of rapid economic growth.

A few brave economists believe fiscal and monetary stimulus, as well as improved productivity, will help the United States bounce back stronger than anticipated, helping it to leap hurdles such as high unemployment, a soaring budget deficit and a beleaguered consumer.

One person not surprised by the recovery taking place south of the border is Brian Wesbury, chief economist at Illinois-based First Trust Portfolios L.P. and author of the book It's Not as Bad as You Think.

"We have said from the beginning that the recession would end quickly and a V-shaped recovery would follow," he says, describing a situation characterized by a steep economic decline followed by a rapid recovery.

Past examples show economies generally power up with annual growth of about 4% in post-recession environments. The bulk of economic forecasters do not expect the United States to sustain such a rapid growth rate this time around because of weak consumer spending. However, there is a school of thought that says it can, and will be done.

Mr. Wesbury says this recession was different from past recessions because it was caused by a dramatic slowdown in the speed money circulating through the economy rather than high interest rates. With the flow of money improving as a result of government and central bank action, he says the U.S. economy would likely grow at a 4% annual rate in the second half of this year, a prediction stronger than most other forecasts.

Based on this outlook, Mr. Wesbury says inflation would likely rise 2% in the second half, a sharp turnaround from the annual drop of 1.5% drop in August. Headline inflation has been kept low because of last year's rapid drop in oil prices from the record high of US$147 in July. These price declines would soon work their way out of the yearly calculations. However, the surge in consumer prices should not be a problem for the economy provided the central bank acts soon to unwind quantitative easing and raise interest rates. Mr. Wesbury says the record low federal funds rate band of 0%-0.25% is too low and could cause problems in the future.

"The sooner the Fed lifts rates, the less inflation and more economic stability the U.S. will have down the road," he says.

Mr. Wesbury is not alone in his call for interest rate increases sooner rather than later. Alan Greenspan, the former chairman of the Federal Reserve between 1987 and 2006, says the Fed would need to roll back its monetary stimulus to keep inflation down amid a "fairly robust" recovery led by productivity and the need to rebuild depleted inventories. He says if the Fed fails to withdraw stimulus promptly, it risks fueling double-digit inflation by 2012.

Mr. Greenspan's advice comes after heavy criticism for keeping interest rates too low for too long during his chairmanship. Many believe his decision to cut the benchmark rate to what was then a record low of 1% in June 2002, and hold it there for a year, was a primary cause of the house price bubble.

For now, U.S. government efforts to rescue the economy from the bursting of that bubble, which put it US$1.4-trillion into the red for the first 11 months of fiscal 2009, appear to be working. Declines in gross domestic product, employment, house prices, retail sales and manufacturing, have become steadily smaller in recent months, beating market expectations.

"Intervention so far has made things better because it has prevented panic and an overly dark long-term outlook in consumers and business," says Daniel Schwanen, deputy executive director, Centre for International Governance Innovation.

John Irons and Ethan Pollack, economists at the Washington-based think tank Economic Policy Institute, say US$62.5-billion in tax relief, as well as unemployment insurance, food stamps and social security, has helped stop the economic slide since the American Recovery and Reinvestment Act was approved in February. However, with just 14% of the US$787-billion package spent, the lion's share of the spending on infrastructure, education and research and development, would hit the economy in late 2009 and into 2010. This spending should not only propel economic growth, but also encourage improved productivity and innovation, resulting in higher profits.

But economists are divided about the long-term consequence of high deficits as a result of the spending. Many say the blowout in public debt will be a thorn in America's side for years to come, resulting in tax increases and crimped spending. The more optimistic do not expect debt to be a major problem for the megalith economy.

In a positive sign, Mr. Geithner, the Treasury Secretary, said last week that budget deficit projections had been revised down because of the improving economic outlook. Furthermore, more than 30 financial firms had repaid $70-billion in Treasury investments, with taxpayers earning a double-digit return on these equity investments. The repayments reduce the government's investment in the banks to US$180-billion. Mr. Geithner said a further US$50-billion would likely be repaid in the next 12-18 months.

Mr. Schwanen says it is possible for productivity to also help the U.S. emerge from its high-debt position. He says such a scenario played out in the aftermath of the Second World War.

Federal debt is predicted to reach 56.6% of GDP in 2009, compared with a record high of 112.7% at the end of the Second World War in 1945, Congressional Budget Office figures show. Debt-to-GDP is expected to widen to 61.1% in 2010. In comparison, Canada's federal debt is projected to increase from 29% of GDP in 2008–200909 -- the lowest debt ratio in 27 years -- to a peak of 35.5% in 2010 to 2011, the Finance Department recently reported.

Mr. Schwanen says the restructuring of the economy as a result of the recession will cause some positive changes. He says capital will be used more efficiently, government spending in research and development will drive innovation and productivity and U.S. consumers will likely take more care not to spend excessively. This last point will play a vital role in rebalancing the global trade flows and reducing the U.S. trade deficit with China.

The Chinese government has begun to encourage its population, notorious for over-saving, to consume, while in the United States job losses and a high rate of loan defaults have taught over-spending consumers to save.

"Growth will be better distributed in effect between China, India, the U.S. and other places," Mr. Schwanen says.

Never before have U.S. companies piled up cash faster compared with interest costs than they are now, setting the stage for a surge in mergers and acquisitions.

As the economy emerges from the worst recession in 70 years, cash flow may rise from the $1.5 trillion reported by the Commerce Department for the year ended in June, according to data compiled by Credit Suisse Group AG and Bloomberg. The amount reached a record in the past 12 months amid the biggest wave of firings since World War II and central bank interest rates near zero percent.

Cash relative to share prices will climb to the highest in at least two decades next year compared with yields on corporate bonds, the data show. The previous high in 2005 preceded the two busiest years ever for takeovers.

“You’ll see a steady return to growth in the M&A market,” said Michael Boublik, the chairman of mergers and acquisitions for the Americas at New York-based Morgan Stanley. “Investors are wanting and demanding that companies start thinking about M&A to fuel growth, so therefore deals are being well accepted.”

Takeover bids by companies from Walt Disney Co. to Kraft Foods Inc. signal increasing confidence among executives that may extend the 57 percent rally in the Standard & Poor’s 500 Index from a 12-year low on March 9. A record amount of mergers helped send the benchmark gauge to its October 2007 high.

This week is slated to be the biggest for initial public offerings in the United States in nearly two years -- and some say the resurgence could be sustainable.

There are eight deals on deck and they are expected to raise $3.5 billion, which would increase 2009's total so far by 66 percent. In an additional sign of strength, they run the gamut from real estate investment trusts created to buy toxic assets to a clean tech company that has never made a profit.

That broadening of industries shows how much the IPO market has healed since a six-month virtual drought ended in February, with the recovery in the IPO market that started in China and Brazil making its way to the United States.

"It's too early to say 'everything's fine, everyone come back into the pool,' but we are seeing signs that more and more types of investors are coming back to the market and there is robust interest in IPOs," said Mary Ann Deignan, head of equity capital markets for the Americas at UBS Investment Bank.

The number of deals could make it the busiest since the week of December 9, 2007, when 11 IPOs came to market. So far this year, there have been only 22 IPOs.

LESS RISK AVERSE?

Among the IPOs ready to test investor appetite for risk is Foursquare Capital Corp (FSQR.N), a REIT that will be run by a unit of money manager AllianceBernstein (AB.N) and plans to raise $500 million with which to buy "toxic assets" under a U.S. Treasury program.

Two other REITs, Colony Financial Inc (CLNY.N) and Apollo Commercial Real Estate Finance Inc (ARI.N), created by Leon Black's private equity firm, are each seeking hundreds of millions to buy commercial mortgage-backed securities, betting that their values will rebound.

IPO investors are becoming more adventurous again.

"Investors are looking more broadly across all sectors now. It's not just defensive names that are appealing," Deignan said.

But a flop or two next week, or a sudden end to the recent stock market rally, could be enough to send investors running for the doors again, an analyst said.

People could be frightened if some of these deals do badly," said Nick Einhorn, a research analyst at Connecticut-based investment firm Renaissance Capital.

Despite considerable buzz, A123 Systems Inc (AONE.O), a promising lithium car battery maker gunning for $225 million, may give investors pause as it would be the first this year by an unprofitable company.

Two of the offerings are carve-outs from large companies: Swiss bank Julius Baer's (BAER.VX) U.S. asset management unit Artio Global Investors Inc (ART.N) ($585 million) and Chinese media company Shanda Interactive's (SNDA.O) spin-off of its gaming unit Shanda Games Ltd (GAME.O) in a $725 million IPO.

Investors have been receptive to carve-outs this year. Shanda Games' rival Changyou.com Ltd (CYOU.O) was carved out of Chinese Internet portal Sohu.com (SOHU.O) and has risen 156 percent since its IPO in April in the best performance of the year, leading some analysts to say Shanda could see the strongest first day jump of this week's crop.

Investors have been rewarded -- 13 of 16 IPOs (excluding REITs) this year have risen since their debuts and the FTSE Renaissance IPO Index is up 41.3 percent, besting the S&P 500 Index's .SPX 18.4 percent rise.

HAPPY BANKERS

The spike in IPOs has come as a relief to investment banks that covet underwriting fees and the prestige of being on the hottest deals.

Of all investment banks, Goldman Sachs, (GS.N) which is co-managing five of the IPOs, stands to gain the most if the coming week's deals all price at expected levels.

Goldman would jump to No. 2 from No. 8 in the league tables for 2009 so far, barely behind rival Morgan Stanley (MS.N), according to projections by Thomson Reuters.

Morgan Stanley would leapfrog over Bank of America Merrill Lynch (BAC.N), which would fall to No. 3 -- though all the top three would be within a hair of each other.

While IPOs remain inherently risky investments, the slew of IPO filings since July point to a sustained spike in IPOs through the end of the year, Deignan said.

Since July 1, 33 companies have filed for IPOs, compared with only 11 in the first half of the year.

Deignan does not think the market will maintain next week's torrid pace but expects two to three IPOs per week to be the norm again in the coming months.

"We could see a good number of those late summer filings come to market this fall," she said.

Those worried about high inflation rates think that once demand starts to pick up, the large money supply will make it extremely easy for consumers to obtain funds and thus inflation will rocket upward.

The odds of this happening are extremely low as the output gap and high unemployment rate do not correlate well with a spike in either consumer or investment demand.

However, let's say this does occur. The Fed is not going to sit back and watch inflation take off.

They can easily pull back large quantities of money by ending their quantitative easing purchases. This can be done by simply letting the Asset-backed Commercial Paper Money Market Mutual Fund Facility, the Commercial Paper Funding Facility, the Primary Dealer Credit Facility, and the Term Security Lending Facility to end when their mandate is up. These programs were not instituted indefinitely and are all set to expire over the next 12 months. The removal of these programs will reduce "easy" money significantly.

They also can sell assets back to the marketplace if need be. The Fed has approximately $800 billion dollars in "legacy" Treasury assets composing of TIPS and nominal bonds and $450 billion in asset backed securities. The liquidity constraints imposed by the market on these assets should ease significantly as the economy rebounds. Demand should become more stable and the Fed can reduce the money supply by selling the securities back to the investors.

In a worse case scenario, the Fed can also drastically rein in the money supply by increasing the required reserve ratios. This tends be thought of as the nuclear option due to the disastrous effects shown after the Great Depression. However, the Fed has given every indication that it has learned from that experience and will make sure that any increase in the reserve requirements will not cause the lending markets to seize up.

The Fed understands that high inflation is creeping into consumer inflation expectations. The Fed has every intention of keeping inflation under control.

As I stated in the past, the Fed will err on the side of inflation. Inflation is also what pension plan sponsors want because it will lower their future liabilities (as rates go up) and increase their assets (as profits grow). Will inflation eventually seep through? I wouldn't bet on it just yet, but you can sure bet on on an other asset bubble to form in the meantime.

Right now, banks are printing money courtesy of subsidized borrowing rates from the Fed. They're also dumping their crappy mortgage assets on the Fed's balance sheet in exchange for fresh cash, thus avoiding further asset write-downs. As soon as the Fed begins to reverse these measures, banks may come under pressure again.

Worse, the Fed is still buying mortgage securities in the open market, thus helping to keep mortgage rates low. If the Fed abandons this crutch, mortgage rates could rise, putting new pressure on the housing market.

Lastly, the government's fiscal stimulus, which has driven some of the rebound in GDP in the last two quarters, will start to peter out in 2010.

Meanwhile, unemployment is nearly 10% and GDP is nearly 4% below its peak. Until hiring resumes in earnest, the government and Fed will likely remain under intense pressure to keep their foot on the gas--lest they snuff out the incipient recovery. On the other hand, if they wait too long, they'll risk a bout of severe inflation.

Whatever happens, Wolf thinks it is highly unlikely that the Fed and Congress will get it just right.

When did the Fed and Congress ever get it "just right"? Mr. Wolf is correct, get ready for a bumpy ride ahead, but before the VIX shoots up, it might first collapse. Stay tuned, things are getting interesting.

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